Alternative to a 15-Year Mortgage: Prepay on a 30

The average rate on a 15-year mortgage offers a pretty significant savings over the 30-year loan. But payments are much larger on 15-year deals because the debt must be paid off twice as fast. Many borrowers just don’t want to commit to that, or can’t afford to.

Fortunately, you can have it both ways — by making extra principal payments on a 30-year mortgage. That way you can pay the loan off early, saving a fortune in interest. Because the interest rate is higher on the 30-year loan, the savings aren’t quite as good as you’d get on a 15-year deal. But that’s offset by flexibility. You could make extra principal payments only when you wanted to, while you’d be stuck with big payments if you got a 15-year loan.

The trick is to make an apples-to-apples comparison that accurately looks at the costs of the two loans.

At the current average rate of 4.709%, according to the BankingMyWay.com Tracker, a $300,000 loan for 15 years would cost $2,327 a month, and interest would total $118,888 over the loan’s life.

At the average of 5.269%, a 30-year loan for the same amount would cost $1,660 a month, with interest totaling $297,653 over three decades. (Use the Mortgage Loan Calculator to try your own numbers and see the effect of prepayments.)

The savings on the 15-year deal are awfully appealing, but paying $667 more a month is not.

The alternative? Take out the 30-year loan and plan to make extra principal payments as often as possible. If you paid an extra $667 every month, ending up with the same payment you’d have with the 15-year deal, interest would come to $143,415 over the life of the loan, and it would take about 16 years to pay off the debt.

That’s a significant savings — $154,239 less interest than if you’d made minimum payments on the 30-year loan.

On the other hand, you’d pay $24,527 more than if you’d taken out the 15-year loan, because the interest rate would be a tad higher on the 30-year deal.

For many borrowers, that’s a reasonable price for the right to pay just $1,660 a month instead of $2,327.

But there’s another benefit to the 30-year-with-prepay approach: it makes cash available for other investments, which could be valuable if market conditions improve.

Extra principal payments are a form of investment that produces a “return” in the form of interest savings. Your rate of return equals the interest rate on the loan, since each prepayment saves you that interest charge.

On the 15-year loan, you earn 4.709% by shouldering those higher payments, while extra principal payments on the 30-year deal would earn 5.269%.

Since these returns are guaranteed, they are comparable to earnings on fixed-income investments like certificates of deposit or U.S. Treasuries. Either mortgage currently offers better returns than you can find with safe fixed-income investments.

But that could change. If 10-year Treasuries started paying 6% or 7%, instead of the current rate of 3.8%, you could stop making extra principal payments on the 30-year loan and put the money into Treasuries instead. You wouldn’t have that option if you were locked into higher payments on a 15-year loan.

Of course, you could also divert that prepayment money to riskier investments like stocks in hopes of even bigger gains. That could easily offset the $24,527 penalty you’d pay by accepting the slightly higher interest rate on the 30-year loan instead of the 15-year deal. And you’d have peace of mind from knowing you’d have flexibility whenever money was tight.